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What is a Roth IRA and Why Should You Care?

I’m going to start a Roth IRA on my own, and I’d like to know what online sites you or your readers would suggest. I want to invest in index funds, having heard they are the bee’s knees, but books and the web, and magazine articles are sadly silent on the HOW, spending lots of time on the WHY.

Right now I’m looking heavily at e*trade and ING. I need to know more about Roths before I make my final decision, although ING is looking the best right now. Vanguard sounds good, but that $3000 minimum is a problem.

This is a big question, and I have a lot of information to share with you, so I’ve divided my response into three parts. Today I’ll provide a brief overview of IRAs. In part two, I’ll explore at how and where to set up an IRA. In the final part, we’ll discuss various investment options.

IRAs are easy — there’s no reason to be frightened of them. Don’t let anything that follows intimidate you. (If you have questions, please ask in the comments.)

Individual Retirement Accounts
An IRA is an Individual Retirement Arrangement, though it’s more commonly called an Individual Retirement Account. An IRA is simply a holding account. It’s a label. When you open an IRA, it contains nothing. Like a bucket, it’s a place for you to put things.

The things you place in your bucket are investments. You might, for example, buy stock through your retirement account. Or maybe government bonds. Some people use their IRAs to buy real estate. And some simply let their cash sit there, earning interest, just as it would if it were deposited in the bank down the street. (Last night I spoke with a friend who had his IRA funds sitting in a savings account, and only yesterday moved the money to an index fund!)

Smart people mix things up over time. Their buckets may contain a combination of stocks, mutual funds, bonds, and real estate. But they don’t have to. Your IRA can contain a single index fund, if that’s what you want.

An IRA is not an investment — it’s a place to put investments.

Types of IRAs
When you use a non-retirement account, you invest post-tax money. Depending on how you invest, you may also be taxed on dividends and capital gains along the way. You’ll also be taxed on the earnings when you sell your investment. An IRA avoids one set of taxes, allowing your money to compound more quickly. The two types of IRAs that you should know about are “traditional” IRAs and Roth IRAs.

With a traditional IRA, the money you invest is probably tax deductible, but the money you pull out at retirement will be taxed at the then-current rate. You don’t get a tax deduction on the money you contribute to a Roth IRA, but at retirement, earnings can be withdrawn tax-free. Put another way: money in a Roth IRA is taxed at the front end, money in a traditional IRA is taxed at the back end.

Unless you earn a lot of money, a Roth IRA is probably ideal for most people reading this site. The rest of this article deals specifically with Roths.

Roth IRA Rules and Requirements
Not everyone qualifies to contribute to a Roth IRA. If your tax filing status is single and you earn more than $95,000, your contributions are restricted. If you are married filing jointly, your contributions are limited if your household income is more than $150,000. Moneychimp explains:

IRAs were created to encourage people to save for their retirement, by offering them a significant tax break. They are intended for ordinary working people — not, for example, the wealthy (income limits prevent them from participating), or trust fund kids too lazy to get a job (contributions have to be made from salary, not from investments or other income).

Check out Moneychimp’s Roth IRA contribution limit calculator to see if you qualify. (The calculator is a little buggy — be sure to start at the top and re-select all parameters if you make any changes.)

Other important facts:

If you are not yet 50 years old, you may only contribute $4,000 to your IRA in 2007 — if you’re older, you may contribute $5,000. (If you go over limit, you are fined on the excess amount. I’m unclear as to whether the rest of the excess can then remain in the account.)

To invest in a Roth IRA in any given year, you (or your spouse) must have earned income. (In other words, you can’t contribute to a Roth if all of your money came from an inheritance during a particular year.)

You can use a Roth IRA even if you have a 401k or other retirement plan.

You must make your contributions by the tax deadline each year.

Reinvestment of dividends and distributions are not counted against your contribution limit.

You can invest in almost anything you want. (Some things — such as life insurance or collectibles — are off-limits.)

You may withdraw your contributions at any time without penalty. If you attempt to withdraw your earnings before the age of 59-1/2, they will be subject to taxes and a 10% early withdrawal penalty (except in special circumstances).

Also — and this is a big one for many people — you may withdraw up to $10,000 in earnings without penalty in order to buy your first home.

There are other arcane guidelines and provisions, but these are the basics.

Where to open an IRA
There are many places to open retirement accounts. Each has advantages and disadvantages.

Many banks and credit unions offer IRAs, but they may only allow the money to be used for certificates of deposit or money market accounts. Big-name mutual fund companies like Vanguard are great places to open an IRA, but they often require a minimum initial investment of several thousand dollars and provide a limited universe of investment choices. Discount brokerages like Sharebuilder and E*trade allow new investors to begin saving for retirement with no minimums, but their fees may be higher.

There’s no one right place to open an account. You will need to search for a place that is good for you. (I’ll explore some options in part two of this series.) Questions to ask during your research include:

Is there a minimum initial investment?

What sorts of fees are assessed to the account?

Does the company offer automatic contributions? What are the limits?

What investment options are available? Can you invest in stocks? Mutual funds? Real estate?

Is it possible to download statements automatically into Quicken?

Remember: the perfect is the enemy of the good. It’s far better to open a Roth IRA now through any provider than it is to delay because you’re worried about finding the number-one best place. Do some research. When you find a place that meets your requirements, open an IRA. Don’t fuss and fret, worrying whether or not it’s the best choice. Find a good choice and go with it.

Conclusion
IRAs are easy. They’re just tax-advantaged holding accounts for your investments. Don’t be frightened of them. For more information check out:

Remember: I’m just learning about IRAs myself. I’m sure to have missed some things. Fortunately, there are some sharp Get Rich Slowly readers out there to clear up mistakes. (I’ll incorporate corrections into the body of the post.)

Addendum: Matt_In_TX has an excellent point. “Please study IRA and taxes for yourself, and also seek professional advice when needed. Not all the information here is necessarily complete or correct for your situation. ” I’ve done my best to be accurate, but this is only an overview. It’s important to do your own research. I am not a financial professional — I’m just a guy like you trying to learn more about money.

Roth IRA Rules and Requirements
Not everyone qualifies to contribute to a Roth IRA. If your tax filing status is single and you earn more than $95,000, your contributions are restricted. If you are married filing jointly, your contributions are limited if your household income is more than $150,000.

JD, I had read somewhere that in 2010 the Roth IRA limits on income will expire and if you have an IRA and don’t qualify for the Roth IRA you can convert it at that time. Do you have any other info. on that?

For the truly lazy (like myself), Fidelity has a fund that’s managed to your target retirement date so you can setup your automatic transfer, pick the fund targeted to your retirement date and forget it until you go to retire. The fund starts out aggressive and gets more conservative as you near retirement. The minimum open is 2k or 2500, but if you do a automatic monthly investment, you can start with as little as 200 a month (no additional minimum). Someone else has a target fund program like Fidelity as well, but I don’t recall who.

As for transferring a traditional IRA to a Roth… due to the different tax structure, I’d be surprised if they let you transfer between the two without some sort of fee/penalty.

Another comment, not entirely related… I’d love to see a post devoted to index funds–what are they, and how can you tell if you have one. I hear how great they are… but at the same time I am not entirely sure how to go about picking them.

Or what about the “target” funds? Are they different than index funds?

Just a thought!

But good entry, I totally agree that the point is to just do it, and if you are looking for the perfect ROth IRA… you are wasting time!

Everybody: I will research answers to your questions. Would you prefer I posted the answers here? Or should I save them for a part four? (Part four would basically be a collection of Q&A about Roth IRAs.)

Does anyone know how the government is tracking these funds? For example, if I am not eligible to contribute for some reason, does anyone know how the government would ever find out about that? The firm you invest with doesn’t care if you’re eligible or not (they never even check), so I’m curious how anyone would know if you were contributing when not eligible? You don’t file anything about Roth contributions on your tax return so I just don’t see how anyone knows. My accountant didn’t know I wasn’t eligible so I made a contribution, now I’m curious what to do.

When you make an IRA contribution Roth or traditional you will get an IRS tax form 5498 because the firm you made the contribution to reports it to the IRS. You can’t cheat the system, They’re gonna find out.

“Unless you earn a lot of money, a Roth IRA is probably ideal for most people reading this site. The rest of this article deals specifically with Roths.”

I could see somebody that has less than 20 years until retirement benefiting from a Roth IRA. However, for somebody with 30+ years of saving for retirement, why would you want to miss out on the magic of compounding interest by investing post tax dollars. I would think that a person with a very long time to invest would more than make up for the future tax liability in a tradition IRA with the investing of the pre tax money.

@Aaron: I transferred my traditional IRAs to Roth when the Roth IRA was first created in the 1990s. There wasn’t any penalty, I simply had to pay taxes on my contributions, which I was able to spread out over two years if I remember correctly.

@cjohnson: You wrote “I would think that a person with a very long time to invest would more than make up for the future tax liability in a tradition IRA with the investing of the pre tax money.” Your argument is based on the assumption that people will invest less in their Roth IRA because it’s done with after-tax dollars (and thus you have fewer dollars to invest). But given the caps on IRA contributions I think that situation would be quite rare in real life. Most people will set a target for their annual contribution (such as maxing out their IRA, regardless of whether it’s a traditional IRA or a Roth) and save for that. If that’s the way you operate, a Roth makes much more sense than a traditional IRA, because you don’t have to pay any taxes on your earnings. If you have a long time to invest, you’ll have large earnings. Being able to withdraw those tax-free (compared with having to pay taxes on your earnings with a traditional IRA) should weigh the advantage very heavily in favor of the Roth.

It’s my understanding that — all things being equal — a traditional IRA and a Roth IRA offer the same returns. In other words, it doesn’t matter when the taxes are taken out if contributions, returns, and taxes are all identical. See the chart at the end of this page for a comparison.

The interest on the IRA gets reported to the IRS along with presumably the type of source account. I’m not sure how much attention is paid to that, but it seems like something that could be flagged automatically during processing.

My preference for the Roth is primarily to give myself some retirement options. I’m already using a 401k for pre-tax contributions, so a post-tax investment in a Roth just gives me some investment type diversity.

I have a Fidelity IRA basically because they manage my work 401k. That was a terrible idea, at least for me. Fidelity has been incredibly unhelpful and their fees for individual stock trades are insane ($20). If you don’t have the 2,500 dollars up front to invest in a mutual fund (which are commission free) you’re just going to have it in a money market.

If you go with Fidelity, and my recommendation is not, don’t bother putting anything in unless you’ve got 2,500 and you’re only investing in mutual funds.

My recollection, wish I could remember where I read the info. about income limits expiring in 2010, is that there is some fee or tax associated with rolling the traditional IRA into a Roth IRA.

On a somewhat related note, Fidelity (my 401k co.) offers something called a Roth 401k option. I’m putting 1% of my 401k contribution into the Roth 401k which is after tax (not sure how it can be called a 401k if its after tax). I haven’t been able to find much more info about this ’401k Roth’ option. Anyone else know anything about it?

@ Sue – When you make an IRA or Roth IRA contribution, the custodian of your account (bank, brokerage, fund co, etc.) reports the details to Uncle Sam. There are penalties if you get caught breaking the rules whether it was intentional or not.

I know many of the questions will be answered in followup posts, so I will add that investors should remember to consider their IRAs as part of their entire retirement savings when balancing and diversifying their portfolio. I.e. A $50k 401k + $10k IRA = $60k retirement portfolio. The funds may be physically separated, but the net effect is that they can still balance each other out for you in the long-run.

Following up, here is some lang. I found on the 2010 expiration for income limits – no idea if this lang. is accurate or not.

Those wishing to convert their IRA from a regular IRA to a Roth IRA must not have income over $100,000. However, in 2010, the income limit for conversion to a Roth IRA is lifted, even while the limit for contributions remains. But, this opens a loophole. Even those who cannot contribute to a Roth IRA or a deductible regular IRA can open a non-deductible regular IRA, as long as they have employment income. The limit in 2007 is $4,000 and in 2008 and beyond is $5,000. In addition, for those over 50, the limits are $1,000 higher. So, in 2007 through 2010, you could contribute as much as $23,000 to a non-deductible regular IRA. Then, in 2010, regardless of your income, you could convert the non-deductible IRA to a Roth IRA.

If you convert a regular, deductible IRA, you would need to pay income tax on the entire IRA upon conversion. However, since you never took a deduction for the contribution to the non-deductible IRA, you would only pay tax on the growth between the date of contribution and the date of conversion. After that, neither you nor your heirs would ever pay a penny in income tax on it. And, it gets even better, because with a Roth IRA, you never have to take withdrawals during your lifetime.

I am almost 30 and both my husband and I haven’t opened Roth IRA accounts yet. We also want to buy our first home in the next year. If we have about 20K saved up by the Roth deadline next year, should we use all the money to put toward a down payment, or use some of the money for a down payment, and the rest to contribute (and open) Roth IRA accounts?

[...] fact, have a love affair with the Roth IRA. (If you’re unfamiliar with it, J.D. has an excellent explanation of the Roth.) But, it is an unrequited love – the Roth does not love me back. Someday, it will. Someday, I will [...]

If I already have a 401k through work, then why would I want to add a Roth IRA? Wouldn’t it always be better just to contribute more (pre-tax) to the 401k? What other options does the Roth give you that I don’t get with my 401k?

@Kevin: What other options does the Roth give you that I don’t get with my 401k?

a) if you’re maxed out on 401k contributions, a Roth allows you to save an extra $4000/year for retirement. (Subject to the contribution limits.)

b) it lets you choose _exactly_ where your funds are invested — in a 401k you’re limited to the funds offered in your employer’s plan, which may be limited and which may have higher costs.

c) it gives you some tax diversification. In basic terms, the save-now-pay-tax-later structure of a 401k (or traditional IRA) benefits you more if you’re taxed less in retirement than now; the save-and-pay-tax-now structure of a Roth IRA benefits you more if you’re taxed more in retirement than now. Having a mixture lets you hedge your bets, both against future tax rates and against any future legislative changes.

For multiple reasons. The simple one is tax diversification. You don’t know what the tax brackets will look like when you retire. You could be paying less now, or you might pay less then. By having a variety of accounts (some taxed now, some taxed then) you “diversify” yourself so that you aren’t shot in the foot when it does come time to retire.

The Roth also has several nice features such as allowing you to pull money out of it (in certain circumstances)…many more options than 401k or traditional IRAs

Publication 590 also has a bunch of worksheets to help determine your individual contribution limits and other tax-related matters. There is an interactive version based on 590 created at Roth IRA Accounts.info.

Both my husband and I have IRA’s through Vanguard. If you roll a 401(k) or retirement plan directly into an IRA they waive the minimum opening amount. So, I was able to open one with only $1200. NOTE: If you are doing a direct rollover, you MUST roll into a traditional IRA for tax purposes. Then, if you have $5000+ you can roll that IRA into a Roth IRA.

My husband opened his so that he can consolidate 401(k)’s and retirement plans when he takes new jobs. Vanguard has been very helpful. When I have questions, they walk me through everything and even answer questions on different funds (we’re using target retirement funds).

I like discount brokerages for my Roth IRA. It’s easy to find a brokerage that doesn’t have maintenance fees, there are lots of investment choices, and it’s easy to change your investments. I use Scottrade, but if I was doing it all over again, I’d use a discount brokerage that does automation reinvestment of dividends, as it is annoying when some of my ETFs spit up a few dollars of dividends every month.

Also, I like to contribute to my Roth IRA as soon as possible. January 1st every year (starting 2007,) I drop my max contribution in.

How about information pertaining to SEP IRAs? If I’m a self-employed individual who makes more than the maximum allowable for a Roth IRA wouldn’t a SEP IRA make sense? I’d really like to know more about SEP IRAs, especially how I can set one up with Vanguard, Fidelity or whoever. More pressing for myself, I’d like to know how to transfer one SEP IRA at one institution (my current bank) to another institution (another bank or some other entity) since most places I’ve asked won’t accept my SEP IRA unless I convert it to a Roth, which would mean I could no longer make contributions.

I’m following this series with avid interest. I grew up poor, and spent the first decade of my marriage that way; I never learned anything about investing because I honestly expected to live paycheck-to-paycheck until the day I die. Now years of budgeting, scrimping, and getting an education is paying off, and it’s scary as hell to realize that I have to start thinking about this stuff and I don’t know anything.

So, here’s my question. I’m not to this point yet – my savings are small and inconsistent (maybe $200 one month, $20 the next, but always something!). But I will be within a couple of years. Should I start looking for a financial institution that offers an IRA I like, and move my general savings to them, so that when I’m ready to start investing I have an account history? Or is there no benefit to keeping everything in one bank?

To begin with, they have a pretty competitive set of retirement funds that are on a par with what you get from Vanguard. The expense ratio is higher (around .76%) but still acceptable, AND you get diversified across some really outstanding mutual funds for the money. (NOTE: I myself invest in their TRRDX, which is their Retirement 2040 fund.)

The other great thing is you can open your T.Rowe Price Roth IRA with $50 so long as you make a monthly systematic automatic investment of at least $50. They also waive small account fees when you make automatic investments each month.

I can’t tell you if this option is right for you, but I think if you’re looking for a Roth IRA this is a good one to check out.
DB

This is excellent! Just what I need at just the right time.
The (very small) company that I work for is starting a 401k plan within the month. I have no idea what the details of the plan will be, but it will be better to understand what my other retirement investment options are before I starting making decisions on my 401k (which will most likely be unmatched).

I’d like to know information from a self employed/small business angle as well. I don’t make enough to be disqualified from a Roth so am I safe in assuming that is still the one to use (versus the traditional one).

I’ve been paying a lot of taxes since becoming self employed, even with estimated tax payments. I think I should be doing something differently.

From my last job I have a Roth account because my 401K was auto rolledover. There’s not much in there and it’s currently in an account with a yearly fee. I want to move it somewhere but don’t know how or where.

For example, move to my regular bank? I qualify for a no fee account because of my balance. Move to ING because I use them for CDs or… ?

Any help in comments is appreciated but of course I’ll be reading this whole series!

Please study IRA and taxes for yourself, and also seek professional advice when needed. Not all the information here is necessarily complete or correct for your situation. Promoting participation in IRAs is laudable, but IRS Publication 590 is over 100 pages long. A few paragraphs and some bullet points are NOT all the information you may need.

On a similar subject, when an investment advisor tells you that he is prohibited from giving legal or tax advice, believe him. I’ve been told things by non-specialists which clearly conflict with information in the IRS publications. Get your professional advice from those with the correct professional standing for the kind of answers you need.

I have to echo what db says, I had my 17 yr old son start up a T. Rowe Price Roth IRA because he can do the $50/month plan. He didn’t have to come up with a large amount to open and the only fee is a $10/yr maintenance.

To sweeten the pot I match 50% of his contributions every quarter. Now to work on my daughter, since she has started a new job……

You’ve all seen the graphic where a young person starts an IRA type account when they are 20 and contribute till they are 30 then stop, they still have more funds than the 30 year old who starts late and continues until they are 65.
Well I wasn’t smart enough to do it when I was 20, not to mention the funding would have been difficult, but hopefully my kids will be in better shape and disciplined with this start.

1. Is there any tax on capital gain / dividend distribution that we have to declare on tax return every year ?

2. I was reading Kiyosaki book about his prediction that in the future when most of the baby boomer/older people start cashing out their 401k/IRA/retirement account (by selling their investment), there’s a chance that market will be affected due to supply & demand rules ?
(price might go down since too many people selling their investment & when price keeps going down people stay away form stock market, this can be a scary situation -> the big bust ??)
i know, nobody can predict the future, but do you think his argument make any sense ?

Rakheem:
on Kiyosaki – its certainly possible, but in reality not everyone will take out there investments at the same time (the baby boom lasted for about 15 years give or take) and most people phase investments. In addition, I’m not sure what percentage of the total market is caught up in 401(K) / IRA funds maybe it wouldn’t be that big of a deal.
If you aren’t in the baby boom, then it just looks like the slight possibility of a big sale on stock at the time which doesn’t sound to me like a bad thing.
In short, I don’t think its something to lose sleep over at the moment.

@Rakheem: You asked “1. Is there any tax on capital gain / dividend distribution that we have to declare on tax return every year?”

No, you don’t (unless my three accountants over the last 10 years were all doing it wrong!)

You asked “3. for Roth IRA, is there really NO TAX at all when we start to withdraw from the account? no income tax? no capital gain/dividend distribution tax?”

The language I’ve seen from IRS implies that some states may impose income tax when you withdraw, but my understanding is that you don’t have to pay any federal income tax when you withdraw — and that applies to both your contributions and earnings, which is awesome.

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